What Is an Adjustable-Rate Mortgage (ARM)?
A variable-rate mortgage (ARM) is a type of house loan with a variable interest rate. The initial interest rate on an ARM is fixed for a set length of time. Following that, the interest rate applied to the outstanding debt is adjusted on a regular basis, at yearly or even monthly intervals.
In most instances, you will have the option of keeping the interest rate set for the life of your mortgage or allowing it to fluctuate up and down. The initial borrowing rates of an ARM are often fixed at a lower rate than that of a similar fixed-rate mortgage.
ARMs are sometimes known as variable-rate mortgages or floating mortgages. The interest rate on an ARM is adjusted depending on a benchmark or index, plus a spread known as an ARM margin. The London Interbank Offered Rate is the most common index used in ARMs (LIBOR).
The fixed period of an ARM can last anywhere between 5, 7, or 10 years. After that, an adjustment period kicks in and the rate of the ARM can go up or down depending on the index used.
Fixed- Vs. Adjustable-Rate Mortgages
You can pick between a fixed-rate mortgage and an adjustable-rate mortgage as a prospective home buyer. So, what’s the distinction between the two?
A fixed-rate mortgage provides more assurance because the interest rate remains constant during the term of the loan. This ensures that your monthly mortgage payment will remain the same throughout the loan duration.
An ARM, on the other hand, may charge less interest during the introductory period, resulting in a reduced initial monthly payment. However, beyond that first term, changes in interest rates will have an influence on your payments. ARMs may become less expensive as interest rates fall. However, ARMs might become more costly as interest rates rise.
Conforming Vs. Nonconforming ARM Loans
Mortgages that “conform” to Fannie Mae and Freddie Mac’s rules are called “conforming loans.” As long as the mortgages meet the financing standards of Fannie Mae and Freddie Mac and the monetary restrictions set by the Federal Housing Finance Agency (FHFA), lenders can sell the mortgages they originate to these government-sponsored organizations for repackaging on the secondary mortgage market.
A loan is considered nonconforming if it does not correspond to the Fannie Mae, Freddie Mac, or FHFA standards. Before committing to a nonconforming loan, it’s important to fully understand the risks involved.
Borrowers may have legitimate needs for a nonconforming mortgage, and the vast majority of nonconforming mortgage lenders are trustworthy companies. You should examine the fine print about rate resets in a nonconforming ARM very carefully before agreeing to the loan.
Types of ARMs
Hybrid ARMs include a fixed- and adjustable-rate period. The interest rate on this form of loan will be fixed at the outset and then begin to fluctuate at a defined period.
This information is often represented by two integers. In most circumstances, the first number denotes the length of time the fixed rate is applied to the loan, while the second denotes the duration or frequency of the variable rate’s change.
A 2/28 ARM, for example, has a fixed rate for two years followed by a variable rate for the next 28 years. A 5/1 ARM, on the other hand, has a fixed rate for the first five years, followed by a variable rate that changes annually (as indicated by the number one after the slash). Similarly, a 5/5 ARM would begin with a fixed rate for five years before adjusting every five years.
Interest-only (I-O) ARM
It is also possible to get an interest-only (I-O) ARM, which entails just paying interest on the mortgage for a certain period of time—typically 3 to 10 years. When this term ends, you must pay both the interest and the principal on the loan.
These programs are appealing to consumers who want to spend less on their mortgage in the first few years in order to free up cash for other purposes, such as acquiring furniture for their new house. This benefit, of course, comes at a cost: the longer you only pay the interest I-O term, the greater your payments will be when it expires.
Think of it as the payments waiting in stasis for you to start paying them. If you take only a short break from paying the principal you will be rewarded with a lower monthly installment. The longer you stay away from paying the principle (because the years remain the same on the ARM), the number of years accrue a higher principal + interest payment. You are spreading the payments over a shorter time; hence they are higher.
A payment-option ARM is an ARM with many methods of payment. These alternatives often include payments that cover both principle and interest, payments that just cover interest, and payments that do not even cover interest.
Paying just the interest or the minimal amount may seem enticing. However, keep in mind that you must repay the lender in full by the date set in the contract, and that interest costs are greater when the principle is not paid fully. If you keep paying off little by little, your debt will continue to grow—possibly to unsustainable proportions.
Refinancing an ARM
An ARM may be appropriate in certain instances, but what if your financial condition changes? To lock in more stability than an ARM can provide, you may refinance your ARM into a fixed-rate mortgage.
Fortunately, the procedure is quite simple. You will take out a new loan to pay off the existing mortgage if you refinance. After then, you’ll begin repaying the new mortgage.
Because you’re applying for a new mortgage, you’ll need to go through many of the same processes you did when you first applied for your ARM. Pay stubs, bank statements, and other evidence of income and liabilities, for example, will almost certainly be required.
Examine current interest rates to see if it is a suitable time to refinance to a fixed-rate mortgage. If interest rates are greater than those on your existing ARM, switching may not be the best option.
Advantages of An Adjustable-Rate Mortgage
ARMs may help borrowers get the lowest interest rate. Many loans provide low initial rates.
Initial low monthly payments may seem like a promotional rate, but they’ll help your budget. You may be able to pay extra on your principal each month.
This economic flexibility is ideal for individuals who want to relocate soon after purchasing a property. If you plan to sell the property before the interest rate adjusts, any changes won’t affect your budget, presuming the sale occurs as planned and you no longer owe the mortgage.
If you’re buying a starter house with plans to improve, you may also enjoy these benefits. If you can sell your property before the interest rate changes, ARM risks are modest.
With an ARM’s lower initial monthly payments, you may accumulate savings and pursue other financial objectives. You might accumulate funds to prepare for a possible interest rate rise beyond the first term.
If you’re relocating to a location where you won’t remain for more than 5 years and want the lowest interest rate on a mortgage, an ARM may be the best mortgage choice for you.
Disadvantages of An Adjustable-Rate Mortgage
An adjustable-rate mortgage (ARM), like other types of mortgages, is not without its potential drawbacks. Taking out a mortgage with an adjustable interest rate exposes you to the significant risk, which is the possibility that your interest rate may go up. Should this occur, you should expect an increase in the amount of your mortgage payment every month.
If interest rates and monthly payments are subject to change, it may be challenging to make accurate projections on your current and future financial situation. If interest rates were to rise, it is probable that you might have difficulty making the larger monthly payments if this occurred. Because of the market’s volatility, prospective homeowners should think twice about getting an adjustable-rate mortgage.
Who Should Consider An ARM?
ARMs may make more sense for certain home buyers, especially those who move often or are looking for a first home. If you’re not looking for a forever home, purchasing an ARM and selling it before the fixed-rate term finishes might result in a reduced mortgage payment.
Of course, there’s always the possibility that you won’t be able to sell your home before your interest rate increases. If you are unable to sell, you should consider refinancing into a fixed-rate or new adjustable-rate mortgage. However, unless interest rates are locked in, they may climb before the conditions of your refinance take effect.